Tag: Phillips curve

Pay growth has been modest by historical standards across many developed economies in recent years, despite tightening labour markets, and Ireland is no exception- average weekly earnings only started to rise again in 2014, and average annual increases of around 1% have been the norm. Unemployment peaked in early 2012 at 16%, and has been falling steadily since, declining to 6.2% at the end of 2017, so one might expect that firms would have to increase pay to attract and retain labour.

Average weekly earnings did pick up through 2017, according to the latest CSO data, rising by by annual 2.5% in the final quarter of the year, which brought the annual average increase to 2%. The growth in private sector earnings last year was lower, at 1.8%, and was outpaced by the 2.6% average rise in the public sector. Pay in the latter is on average 41% higher than in the private sector, but has generally lagged since 2008, when the differential was 46%.

Average pay masks large differentials across the various sectors in the economy and the the recovery has been kinder to some workers than to others; the earnings of workers in Information and Communication, Scientific and Professional services and Adminstration and Support have all significantly outstripped the average growth in pay, while the Financial sector has recently recorded strong pay growth after steep falls during the recession. Surprisingly, perhaps, pay in construction is not as buoyant as one might imagine, with average earnings barely increasing in 2017 and still below the 2008 level.

Consumer prices rose by only 0.4% last year so a 2% pay rise translated into a 1.6% increase in real earnings. Nominal pay growth is generally expected to accelerate in 2018, given the further erosion of slack in the labour market, although, as seen elsewhere, the traditional relationship between unemployment and pay growth, the Phillips Curve, has become much flatter,

Longer term euro interest rates have moved higher over the past few weeks as the market starts to adjust to what it perceives as an imminent change in monetary policy from the ECB. 10-year German bond yields are trading at over 0.5%, which is still extraordinarly low but compares with a yield of only 0.25% at end-June, so the speed of the move has surprised. A ‘reflation’ reference by Draghi was the initial catalyst ( although later played down by the ECB) and the pace of economic activity has certainly picked up this year but the problem for the hawks in the Governing Council is that inflation remains stubbornly below target (1.3% in June), with the core rate still remarkably low (1.1%).

GDP in the Euro area (EA) grew by 0.6% in the first quarter and strong survey readings (the IFO in Germany is currently at a record high) imply a similar if not stronger figure for q2. On that basis it now seems likely that annual growth in the EA may emerge at 2.1% or 2.2% this year and hence above the 1.9% projected in the June ECB staff forecast. There have only been two previous tightening cycles by the Bank, and the IFO is currently well above the level that has previously triggered higher rates, but , to date, the pick up in economic activity has not put any material upward pressure on prices.

The persistence of low inflation , not just in the EA but across other developed economies, notably the US, has prompted a lot of analysis.What is striking is the behaviour of wages, as they have not responded to tightening labour markets in the expected way. That relationship is generally known as the Phillips curve, and the evidence shows that the curve is now much flatter than in the past i.e. a given fall in unemployment has very little impact on wages. So, for example, EA unemployment has fallen from 12.1% to the current 9.3% but wage inflation in q1 was only 1.4% and averaged 1.5% in 2016.

A range of factors have been put forward for this limp growth is wages; low price inflation, the decline of trade unions, globalisation, the growth of self employment and changes in the structure of the jobs market. Many of these factors are structural and if so, the acceleration in wage inflation expected by the ECB over the next few years may not materialise, despite stronger GDP growth.

The ECB also now tends to emphasise core inflation more than it did under the previous President, but the inflation target is set in terms of the headline rate, and most research shows that to be strongly influenced in the shorter term by commodity prices and the exchange rate. Consequently, the recent fall in oil prices and the appreciation of the euro ( up 8% against the US dollar in the past three months), unless reversed, would normally prompt a further downward revision in the the next ECB inflation forecast in September.The June forecast itself reduced the inflation projection over the next three years by a cumulative 0.6 percentage points, largely reflecting weaker oil prices. Another point worth noting is that credit growth, although stronger than last year, is still anaemic, a factor referred to in the latest ECB minutes.

So what is the market expecting? It would be difficult for the ECB to claim that there are upside risks to inflation but having stated that the risks of deflation have effectively disappeared the Bank may tweak it guidance on asset purchases, which currently states that ‘we stand ready to increase our asset purchase programme in terms of size and/or duration‘. In reality, the scope to increase QE is anyway constrained, as in a number of cases the Bank is at or close to the 33% issuer limit in government bonds. However, the market does not expect an immediate halt to buying by the end of the year, rather a gradual tapering of the monthly total into 2018.

Yet the ECB would find itself in a difficult situation if inflation fell further over the next few months, as it has argued that QE has been instrumental in boosting the price level and that ‘ a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term’. The Fed also faces low inflation but can point to its dual mandate ( stable prices and full employment ) to justify tightening, but the ECB does not have that luxury.